On September 7, 2022, the Bank of Canada (BoC) continued its fight against soaring inflation by raising its target for the overnight lending rate to 3.25%. Since March this year, Canada’s central bank has hiked interest rates by 3%.
The BoC’s ongoing rate increases have not been kind to homeowners, primarily those who hold variable-rate mortgages. And with further rate hikes anticipated, many risk hitting what’s known as the “trigger rate,” which can have significant implications for their future mortgage payments.
In short, exceeding this threshold may result in higher mortgage payments – a bleak prospect for Canadians already struggling with rising living costs and other debt.
Do you have a variable-rate mortgage with fixed payments and are concerned about the consequences of hitting your trigger rate? If so, it’s wise to become familiar with this obscure but increasingly relevant concept.Contact A Trustee
In this article, we’ll explain:
- How trigger rates affect variable-rate mortgages
- How to determine your trigger rate
- What happens to your mortgage payments once you hit your trigger rate
- How to prepare financially to better manage your mortgage payments
What is a trigger rate, and how does it work?
The trigger rate is the interest rate at which your fixed mortgage payment no longer pays any of the principal and only the interest. If such a situation persists for too long, your financial institution can adjust your mortgage payment.
Trigger rates apply only to variable-rate mortgages – they don’t impact fixed-rate or adjustable-rate mortgages.
How trigger rates affect variable-rate mortgages
Knowing how variable-rate mortgage works is essential to understanding the logic behind trigger rates.
With a variable-rate mortgage, you pay a fixed payment at a specific time interval, such as monthly or bi-weekly. Your payment amount never changes during your mortgage term. However, the interest you pay with each payment may rise or fall as time goes on.
Your variable-rate mortgage rate fluctuates based on changes in your lender’s prime rate, which typically moves in tandem with the overnight rate.
For example, each time the BoC raises the overnight lending rate, the result is a higher prime rate. And when your lender’s prime rate increases, so will the rate you pay on your variable mortgage. But since your payment is fixed, your lender will apply a larger portion of it to interest and less toward the principal.
Should rates climb high enough, you’ll find yourself in a situation where your lender applies the entire payment to interest charges and nothing toward your principal. It’s at this stage that you’ve officially hit your trigger point.
Here’s an example to illustrate the concept:
Suppose you buy a home in Toronto in January of 2022 and finance the purchase with a $400,000 variable-rate mortgage. You negotiate with your lender the following terms:
- 1.50% interest rate
- Five-year term
- 25-year amortization period
- Monthly payments
Below is a table that shows how much of your monthly payment your lender would allocate to interest as your mortgage rate rises:
|Overnight lending rate||Your variable- mortgage rate||Total Payment||Interest portion||Principal portion||Percentage of payment applied to interest|
As you can see, you’ll continue to pay $1,599 even as your mortgage rate rises. But interest charges will consume an increasingly larger portion of each payment. Eventually, you’ll reach the point where 100% of your payment goes toward interest.
Why do lenders add a trigger rate to variable-rate mortgages?
Your lender adds a trigger rate provision in your variable-rate mortgage contract to ensure you’re building equity with each payment you make. Naturally, if your entire mortgage payment covers interest charges only, you’re not gaining any equity.
Even worse, let’s say your fixed payment is insufficient to pay the interest. What this means is that your mortgage balance is growing rather than shrinking. This scenario is called negative amortization.
In our previous example, you’d have a shortfall of $68 if your mortgage rate were to climb to 5%. Technically, your lender would defer the $68 your regular payment fails to cover. They’ll add it to your outstanding balance, meaning your mortgage will increase in size – not good!
How your lender sets your trigger rate – and where you can find it
There are no universal standards lenders use to calculate trigger rates for variable rate mortgages – each has its unique method. In addition, lenders evaluate each mortgage individually, factoring in aspects like the contracted interest rate and payment size.
So, how do you go about finding out your trigger rate?
The easiest way is to examine your Mortgage Loan Agreement – it’ll be stated clearly in this document.
However, remember that your trigger rate isn’t set in stone and can change over time. For example, your trigger rate increases if you make a prepayment during your mortgage term. The reason is that a prepayment reduces your principal, which means fewer interest charges will accrue going forward.
Though it’s challenging to determine your trigger rate precisely, there are online calculators available that can provide you with a rough estimate. Mortgage expert Ross Taylor offers one such tool (developed by Francis Hinojosa, CEO of Tribe Financial Group) on his website.
You can also contact your lender directly and ask them what your trigger rate is – this option will provide you with the most accurate answer.
What happens if you reach your trigger rate?
Let’s say you reach your trigger point. In that case, your lender will inform you that your regular payments no longer cover any principal. They’ll recommend several solutions to get you back on track in paying down your loan’s balance:
- Increase your fixed payment – By adjusting your payment upward, you’ll have more room to allocate a portion to the principal. However, your mortgage contract may have specific rules regarding how much you can add on top of your existing payment.
- Contribute a lump sum payment – By making a prepayment against your mortgage, you can push up your trigger rate threshold. As with increasing the size of individual payments, your mortgage contract may restrict you to a maximum prepayment.
- Lengthen your mortgage amortization period – Another way to alter your payment size is to increase your mortgage amortization period. However, depending on your mortgage type, this option may not be available to you.
- Convert to a fixed-rate mortgage – You may have the opportunity to switch to a fixed-rate mortgage contract. Remember that fixed-rate mortgages are typically more expensive than variable-rate mortgages, so your regular payment may increase significantly.
As you can see, you may have several options at your disposal upon breaching your trigger rate. But what’s crucial to understand is that you’re not obligated to act at this point. You can continue making your scheduled payments as though nothing has changed.
However, you must act once you’ve reached your mortgage’s trigger point.
What happens if your reach your trigger point?
Suppose you decline to readjust your mortgage after exceeding your trigger rate. In that case, your lender will keep adding more and more excess interest charges to your loan balance. Eventually, you’ll hit your mortgage’s trigger point.
The trigger point is when your balance owed surpasses the original principal of your loan. It occurs when too many deferred interest charges accumulate on your outstanding balance.
From your lenders’ perspective, hitting your trigger point brings you dangerously close to defaulting on your loan. As a result, they’ll promptly notify you and compel you to act by adjusting your mortgage payments, applying a prepayment, or converting to a fixed-rate mortgage. Typically, they’ll give you 30 days to decide.
Worried about being unable to afford your mortgage payments due to hitting your trigger point? Here’s how to prepare so you can avoid losing your home.
It pays to be proactive if you anticipate higher mortgage payments in the near future. Top up your savings account, slash your expenses, and consider taking on a side hustle. The more money you have available to weather a rising-interest rate storm, the easier it’ll be to manage your mortgage payments as they increase.
However, not everyone has the privilege to boost their disposable income at will. Perhaps you have little or no additional funds to work with, as you face a mountain of other debt: credit cards, lines of credit, payday loans, etc. Maybe the Canada Revenue Agency (CRA) is also chasing you for unpaid income tax.
Luckily, a little-known government-sponsored program in Canada can help you eliminate a huge chunk of your high-interest, unsecured debt. This program is called a consumer proposal, and it’s administered under the guidance of a Licensed Insolvency Trustee – the only professional with the expertise and authority to carry it out on your behalf.
By filing a consumer proposal, you can negotiate with your creditors to reduce your unsecured debt by up to 80%. This includes credit cards, lines of credit, payday loans, and even taxes you owe to the CRA. As a result, you’ll have more cash handy to keep up with your mortgage payments successfully – and ensure you don’t lose your home to foreclosure.
Book a free consultation today with David Sklar and Associates to explore your options and see how much debt you can eliminate.